The Bull Bear Trader discusses market events and news with an interest in understanding risk and return in both bull and bear markets. Discussion topics include trading and hedging strategies, derivatives, risk management, hedge funds, quantitative finance, the energy and commodity markets, and private equity, as well as an occasional investment opinion.

Wikinvest Wire

Some of the same financial engineering that contributed to the recent credit problems is being used to provide liquidity during the recent credit crunch - with the help of the new Fed Primary Dealer Credit Facility. Apparently, Lehman Brothers has moved about $2.8 billion in loans and risky LBO debt to an off-balance sheet structured investment vehicle, which then issued debt securities that were backed by the loans and debt. The vehicle used was a CLO (collateralized loan obligation), which was split into two parts (tranches). The first part, around $565 million, was not rated, but was structured to incur the first 20% of losses. The second part contained the remaining $2.26 billion in securities. Since the pool would need to lose at least 20% before the second part would suffer losses, credit rating agencies assigned it an "A" rating - yes, those same agencies that many don't really trust anymore.

This is the point where the Fed comes in. Since the $2.26 billion has an investment grade rating, Lehman can pledge it as collateral, utilizing the Primary Dealer Credit Facility to obtain low interest, short-term loans. Why all the trouble? The Fed only takes securities that have market prices and investment grade ratings. The risky LBO junk rated debt does not qualify. This is where the CLO comes in, allowing Lehman to create an entirely new vehicle with investment grade ratings.

Of interest is how some on Wall Street are calling the move "brilliant," allowing "investment banks to get liquidity from assets that they don't want to sell at fire-sale prices," while others are disgusted that the credit rating agencies are being used again in this way. Finally, some just think the move was more of a test to see what the Fed would accept. I guess now we know.